12 Principles of Business Finance
Business finance involves the application of the principles of general management to a particular financial operation. In respect of specific financial operations, the financial manager plans, organize, directs, and controls to further the ultimate goal of finance.
The goals of finance are addressed through the principles of business finance, which can be placed in investment decisions, financing decisions, and others.
Investment involves allocating resources among various types of assets; What proportion of the firm’s funds should be invested in financial assets (cash, receivables, securities), and what proportion in real assets (equipment, plant, land).
The asset mix affects the amount of income the firm can earn.
Besides determining the asset mix, financial managers must also decide the types of financial and real assets to acquire. The investment principle specifies the company should not invest in assets that earn less than a minimum acceptable required rate.
Financing involves funds for the firm. Thus, while investment decisions are related to the asset side of the balance sheet, financing decisions are related to the liabilities and equity side.
When firms make financing decisions, they must consider a member of factors, including capital structure, risk, cost, availability of funds, timing, and distribution of earnings.
The financing principle posits that firms should use a mix of debt and equity that maximizes their value.
At first, the principle of the firm is to maximize profits. Many firms believe that as long as they are earning as much as possible while holding down costs. Profit maximization has the benefit of being a simple and straightforward statement of purpose.
The second frequently encountered principle of a firm is- to maximize the value of the firm over the long run. This principle may also be stated as wealth maximization, defined as the firm’s net present worth. The wealth maximization principle is linked to the long-term profitability of the firm.
When a firm borrows funds, the lender expects to be repaid according to the terms of the loan agreement. If the firm cannot raise sufficient revenue over time to repay the borrowed funds, it will go bankrupt- the ultimate risk for a firm.
So, financial decisions involve risk-return trade-off principles of action.
Time Value of Money
People prefer to receive a given amount of money now rather than at some time in the future. The principle of the time value of money making the correct decision may make the difference between profit and loss.
The cost principle is to minimize the cost of funds to maximize wealth. It involves examining all alternative sources of financing.
The capital structure of a firm is its mix of debt and equity. The capital structure principle decides which mix is best for the firm. Several factors affect a firm’s capital structure; one of them involves the firm’s expected return.
Liquidity and Profitability
Liquidity means that the firm has adequate cash to meet its obligations at all times. The profitability requires the firm’s operations to yield a long-term profit. These two are similar but overlapping. Achieving liquidity under the liquidity-profitability principle requires minimizing risk and maintaining control over the firm’s activities.
Flexibility is gained by careful management of funds and activities. Finance attempts to be as flexible as possible in providing the funds needed to support the firm’s development.
The principle of asset selection, which considers the combined risk of all assets held by the firm, became an increasingly important tool as the relationship between risk and return became better appreciated and understood.
Shareholders may expect to receive some of the firm’s earnings as cash dividends. However, retained earnings may represent an important source of funds for the firm.
The dividend principle decides how much of the firm’s earnings should be paid out and how much should be retained. The dividend principle argues that firms that do not have enough investments that earn the expected rate of return the cash to the owners of the business.
Another principle of finance is that it lets the firm know when financial decisions will have to be made. To make effective decisions, these principles must analyze and plan.